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Wells Fargo & Company (WFC - Analyst Report) is all set to lose significant amount of interest income in the coming years due to refinancing the mortgages arising out of the foreclosure settlement. The company stated this in its most recent quarterly filing.

Wells Fargo will be refinancing the mortgages of around 33,000 to 36,000 borrowers, having an unpaid principal balance to the tune of about $6.7–$7.4 billion. As a result, the company anticipates reduction in interest income in the range of $1.8– $2 billion ($181–$200 million annually), which is $300 million higher than the prior estimates.

Further, based on mix of loans to be refinanced, Wells Fargo expects a 270 basis points dip in the weighted average note rate and weighted average remaining life of these loans is anticipated be 10 years. However, the actual number of borrowers opting for refinance will definitely affect these estimates.

Under the refinance program, Wells Fargo is entitled to earn an additional 25% credit for all refinance credits earned in the first year of the program. If the company achieves the target, it will earn an extra credit of up to $350–$390 million. Moreover, the company anticipates total earned credit from this program to be approximately $1.7–$2.0 billion.

The forgoing of interest income stems from the agreement that Wells Fargo, along with Bank of America Corporation (BAC - Analyst Report), Citigroup, Inc. (C - Analyst Report), JPMorgan Chase & Co. (JPM - Analyst Report) and Ally Financial Inc., reached with the attorneys general of 49 states and several federal agencies in February this year, over alleged faulty foreclosure practices. The total settlement amount was $25 billion.

Wells Fargo’s settlement share of $5.3 billion includes $900 million in a refinance program, $3.4 billion in consumer relief programs and $1.0 billion in foreclosure assistance payment to the Federal government and the states.

Wells Fargo expects the impact from the interest income loss to be spread across several years. The company anticipates the low interest income to negatively impact the net interest margin, which is already pressurized in the low interest rate scenario. As of September 30, 2012, NIM stood at 3.66% compared with 3.84% in the prior-year period. Also, the refinance program is expected to reduce the fair value of the loans refinanced in the region of $1.4 billion to $1.6 billion.

Yet, we believe that robust capital levels, prudent expense management as well as improvement in credit quality, albeit at a slow pace, will support Wells Fargo’s financials going forward. Further, stress test clearance and sound capital deployment activities will boost investors’ confidence in the stock.

Wells Fargo currently retains a Zacks #3 Rank, which translates into a short-term Hold rating. Considering the fundamentals, we also maintain a long-term Neutral recommendation on the shares.

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